Monday, April 23, 2012

Andy Xie warns that Hong Kong's dependence on the housing sector to drive economic growth is feeding another asset bubble. When it bursts, he says, the government should resolve to kick the addiction

Andy Xie

April 23, 2012

Hong Kong did not learn from the property crash and economic collapse of 1998. Instead, it has tried hard to reinflate the bubble. After squeezing supply for over a decade and with the help of the US Federal Reserve's zero interest rate, the bubble is back. But it is a Pyrrhic victory.

Hong Kong's economy is suffering. Between 1997 and 2011, nominal gross domestic product grew by 2.6per cent, per capita income by 2per cent, and the average salary by nearly 2per cent every year. Over the same period, the cost of living shot up - oil prices quintupled and food prices doubled - while China's labour costs tripled. It's easy to see why Hong Kong people are not happy.

More damaging is how concentrated in property and finance the Hong Kong economy has become. In 1997, aside from the property bubble, Hong Kong was leading the Pearl River Delta's industrialisation with the attendant high-valued-added activities such as research and development, trade finance and marketing based in Hong Kong.

But the high cost of doing business due to high property prices and rent has pushed away such businesses. The only new business that has helped Hong Kong is retailing to mainland tourists. But selling European products to Chinese tourists is a low-value-added business. Only landlords benefit significantly from it.

The social cost of squeezing supply to support a high price could precipitate social turmoil. While Hong Kong is considered a high-income economy, numerous families, many with members of three generations, live in one room. More than two-thirds of Hong Kong's land is undeveloped. And reclamation, the main source of new land for Singapore, has potential in Hong Kong. So, while popular perception attributes high property prices to a land shortage, it is utterly untrue. Hong Kong's elite fuels this misperception because they want to keep people in the dark.

Despite its gross mismanagement, Hong Kong hasn't collapsed because it can suck juice out of China. Hong Kong's prosperity depends on arbitrage opportunities arising from the mainland's inefficiencies. As the mainland becomes more efficient, such opportunities will become scarcer.

Mainland prosperity has also created a new business for Hong Kong - monetising China's political power offshore. This round of Hong Kong's asset boom has much to do with this force. That business, however, won't last, either. China's political reforms will come sooner than expected.

No great city can thrive just on dodgy businesses like property speculation, arbitrage exploiting someone else's loopholes, or helping powerful people rob their countries. True, such businesses also exist in London and New York. But those cities have diversified activities to provide a decent living for the local populations, even as the elite profit from the dodgy activities. If Hong Kong's economy is to thrive, it must make Hong Kong people competitive.

After the 1998 collapse, the Hong Kong government took to setting a minimum price for land auctions. As the government is the only land supplier, it caused the economy to restructure around the government-mandated land price. Economic activities that compete globally couldn't survive in such an environment and decamped as a result. On the other hand, Hong Kong's Cantonese education has produced a generation ill suited for economic activities related to serving mainlanders' needs, dodgy or otherwise.

Hong Kong's economic winners and losers are determined by a game of when one buys a property. This game redistributes income; it doesn't make the pie bigger. Because land supply is controlled, downstream activities are just ripples in a river where the water level is fixed. Hong Kong's market economy, while often touted as laissez-faire, is not really market oriented.

Unless Hong Kong cuts property from its economic centre, it doesn't have a good future. Property isn't a productive asset. It is worth money only because the people who use properties are competitive. When policy squeezes up property prices by restricting supply, it just prices more and more people out of the modern economy. As their numbers accumulate, discontent will grow.

Hong Kong must control land supply according to its development needs, not to set prices. The city should first set targets for the size of its population and housing conditions - say, a minimum living space of 200 square feet per person - and land supply should follow. The current property bubble will eventually burst, like the ones before, when the US Fed raises the interest rate. And when it does, the government must resist manipulating supply to support prices. It should be viewed as an opportunity to restructure the economy.

To control the damage from a property crash, the government should tighten prudential regulations on the banking system. Hong Kong has an unusual capital accounting requirement for mortgage lending. At 8per cent of the standard capital requirement for lending, Hong Kong banks essentially need no capital for mortgage lending. This is why Hong Kong's mortgage interest rate is so low.

Hong Kong's banking system is a massive volatility amplifier for the property market. It may be good for developers, but it's not good for the economy. Raising the requirement to 50per cent, as it stands in mainland China, is a step that the government can take immediately to strengthen the economy.

Thursday, February 9, 2012

Andy Xie urges the Chinese government to embrace the restructuring that is needed to sustain economic growth, instead of using its financial muscle merely to delay the inevitable - a painful transition

China's obsession with stability may lead to greater instability. A skilful person can keep a ball on a bigger ball only for so long. China's economy faces serious structural problems. Reshuffling liquidity to keep everything afloat for now will lead to a collapse later. The right way forward is to accept restructuring, deal with the pain, and be reborn into a more dynamic economy. This way, China could become the world's largest economy in 10 years.

China has experienced a tremendous economic boom, the result of it joining the World Trade Organisation, its demographic dividends, and its building of infrastructural networks. China's nominal gross domestic product has almost quadrupled over the past decade to an estimated 47 trillion yuan (HK$58 trillion) last year, with exports up more than seven times in US dollar terms, while electricity consumption, the best proxy for real growth, is up by over 200 per cent. Prosperity on such a vast scale has never occurred before. China should be proud of its achievement.

Amid the prosperity, two related forces have been sapping China's dynamism: the rise of the state sector and a vast financial bubble. Fixed-asset investment, dominated by government and state enterprises, rose from 2.8 trillion yuan to 31 trillion yuan, or from 30 per cent to 65 per cent of GDP, over the past decade. It is a symbol of the nationalisation of demand during the boom. Its two consequences are rising corruption and declining efficiency. The bubble, especially in property, has diverted the energy of businesses and households towards speculation to chase quick profits. Amid rising costs, China's businesses have tried to stay alive through speculation rather than by increasing efficiency and upgrading products.

China's bubble isn't a result of investors overreaching. In this system, every bubble-making opportunity is seized upon because it benefits the government and the people with influence. The productivity gains from joining the WTO, the demographic dividend and infrastructural build-up should go into raising profits and real wages. But, through rampant monetary expansion and government manipulation of the land market, the productivity gains have gone into supporting a giant credit-cum-land bubble.

The bubble has begun to deflate. Many blame the government's tightening measures, but they have merely brought forward the inevitable, because the bubble was already unsustainable. The WTO dividend is gone. The depressed global economy is turning China's export dependence into a weakness. Population ageing is causing labour shortages, shifting money from asset inflation to price inflation. And, the quantum benefits from building infrastructure have mostly been absorbed.

The right way forward is to: first, quickly deal with the bad debts from the bubble bursting; second, rebalance demand from the government to the people through tax cuts; and, third, to boost supply-side efficiency through industrial consolidation.

China's banking system has 110 trillion yuan in total assets or 234 per cent of GDP. While the reported loans are about half of those assets, a majority of the assets are loans to local governments and businesses, directly and indirectly. Much of the lending to businesses is also outside the banking system. And we know that most loans in mainland China go into property. China's property and land prices are likely to plummet from the peaks. Yet many more properties are under construction. China's bad debts could easily go into trillions of yuan.

China reported fiscal revenue at 22 per cent of GDP and industrial profit at 12 per cent of GDP in 2011. The household disposable income survey suggests household income was 40 per cent of GDP. Suffice it to say that China's income distribution is heavily skewed towards the government and state-owned enterprises; household disposable income is low, and this is why China's consumption is low.

On the supply side, China suffers extreme fragmentation and overcapacity. When labour and capital were cheap and supply was endless, such an industrial structure could survive. But, as China's demographic headwind pushes up wages and inflation pushes up capital costs, most businesses in China are having trouble. To survive, numerous companies have turned their core businesses into a fund-raising platform for property speculation. This strategy is backfiring as the property market heads south.

China's bubble has covered up many structural problems. The bubble worked when the benefits from other sources were available to sustain it. As the latter vanish, the bubble deflates. Obviously, it is painful to deal with all the problems at the same time.

The obsession with stability may be pushing China towards a stalling strategy. China's vast foreign-exchange reserves give it the freedom to maintain domestic liquidity regardless of the quality of the banking assets or hot-money outflows. The lack of liquidity pressure means China doesn't have to press bankrupt developers and inefficient businesses to sell out or liquidate. But that could lead to a Japan-style equilibrium with zombie banks, zombie companies, and zombie local governments.

Unlike Japan two decades ago, China's labour costs are still low. It is possible that, through multinational corporations and new companies at home, Chinese workers will become more productive, for example, by competing against their German and Japanese counterparts. The resulting rising tide could solve China's problems. But this strategy needs luck, and time, to work.

It would be far better to control one's own destiny through restructuring to become more productive on the supply side and more balanced on the demand side. But the prospect of that seems low for now. China's economy may take a long pause.

Monday, January 16, 2012

China's economy is slowing down due to export weakness and a bursting property bubble. Unless painful structural reforms are undertaken, the slow growth may be here to stay.

China has excessive debt in the corporate sector due to property speculation, excessive fragmentation of the supply side due to local government subsidies, and unsustainable dependency on investment on the demand side. Export slowdown and property bubble bursting expose their drag on growth. Unless structural reforms deal with these problems, China is entering an era of slow growth-GDP growth rate down by one third or more compared to the record in the last decade.

The structural problems are unlikely to be cured in the foreseeable future. China is likely to avoid widespread business bankruptcies, which is necessary for balance sheet cleansing and supply side consolidation, by forcing banks to prop up unprofitable businesses. This dynamic will suppress economic growth rate.

China's per capita income reached $5,000 in 2011. It is less than half of the global average and one tenth of the OECD level. China has the potential to continue high growth rate until $15,000 per capita income. However, the will to embrace painful reforms, necessary to realize China's full potential, isn't here.

Too much debt

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China's debt is concentrated in the business sector and local governments. It appears that both are excessively in debt and will have trouble expanding through more debt. At a glance China's economy isn't excessively levered. The domestic credit at Rmb 65 trillion reported in October 2011 is about 145% of GDP. It is not alarmingly high by itself. But, the off-balance assets in the banking system and the lending activities outside of the formal financial system may add considerably to the country's indebtedness. The financial institutions have total assets of two times GDP. And the country's officially recognized financial assets are about 2.6 times GDP. These two numbers indicate that the lendings outside of the officially recognized financial system are considerable. China's total indebtedness of its non-financial sector is probably above 200% of GDP.

The concentration of China's debt in local governments and businesses is a big problem. Local governments usually have debts over three times revenue. There are examples of over ten times. Corporate debts in many coastal townships are above two times the local GDP. Such high leverage is difficult to sustain. It is quite likely that both sectors are having trouble paying off their debts.

Corporate debts usually go into property investments that in turn become revenues for local governments. As the property bubble bursts, the revenues for local governments will come under pressure. That increases the difficulties for local governments to pay off their debts.

The inability to pay off debts is not likely to lead to bankruptcy. The recent trend suggests that the banks will roll over the loans to governments or businesses despite their inability to repay.

Fragmentation of the supply side

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Most businesses in China seem to have a large number of companies, while similar industries in the rest of the world are consolidated into a few players. Low entry costs are the reason for China's fragmented industrial structure.

Local governments keep entry costs low to promote investment. Land is commonly free for industrial use. The environment protection cost is usually low. Until recently, credit and labor were cheap and plentiful. In an environment of low entry costs, market growth leads to more entries. Hundreds or even thousands of companies are doing the same thing across most industries.

The fragmented industrial structure is running into trouble due to rising labor and credit costs. A fragmented industry has no pricing power. When costs rise, only bankruptcies could shrink output, increase prices, and restore profitability. The logical ending in this process is the emergence of large players that develop brand, quality, intellectual properties, and economies of scale as entry barriers.

However, the consolidation process led by market force is unlikely to proceed normally. The lenders are under pressure not to pull the credit lines on struggling businesses. That means that the industrial sector couldn't improve efficiency to deal with rising costs.

Unbalanced demand

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Excessive investment, led by local governments and state-owned enterprises, has become the central pillar for demand management in China. As debts pile up, more investment with new debt has become the only option to keep liquidity positive. This dynamic of riding the tiger is leading the Chinese economy to become more and more skewered towards investment.

In 2001 the reported urban fixed asset investment ('FAI') was 25% of GDP. It surged to 43% in 2006, 60% in 2010, and an estimated 65% in 2011. The increase in the FAI over the past decade exceeded three quarters of GDP increase. The trend is simply crazy.

China's FAI is supply-driven, i.e., it starts with a government project. The government concerned then tries to raise revenues in whatever way at its disposal. As government power is unchecked, such dynamic inevitably leads to squeezing the household sector through whatever channels. High property price, inflation, taxes, or fees all lead to the same end: funding government projects.

The reported FAI could be exaggerated due to leakages in the expenditures. China's gray income could be one tenth of GDP. Much of it comes out of FAI. Such redistribution of income from the masses to a privileged few is not good for social stability. That is one reason that the FAI trend is bad for the country.

Leakages aside, some of the massive investment is just waste. The image projects are visible everywhere. China's per capita income is less than half of the global average. It doesn't make sense to waste money on such a scale.

Stimulus could backfire

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China's economy is slowing significantly since the summer of 2011. The eurozone debt crisis was the trigger. It appears that Europe is experiencing a deeper recession. It is the largest trading partner for China. The bursting property bubble at home is adding to the slowdown. The property bubble has been the liquidity machine turning bank loans to property developers and buyers into revenues for local governments that leverage up the receipts further with bank loans to fund FAI. The breakdown in this liquidity machine has forced many governments to stop FAI projects.

As the slowdown continues, there will be calls for monetary and fiscal stimulus. Such stimulus will merely go into FAI again, prolonging the problems in the economy. Inflation will follow such stimulus. It is just taxing the currency holders to finance inefficient FAI. While stimulus for propping up FAI isn't a good idea, it may happen anyway in 2012. The resulting inflation will cause public outcry and pullback of such stimulus.

China's current slowdown isn't just a cyclical phenomenon. The country's investment-and export growth model is running into a wall. Global trade isn't likely to return to high growth. Without export boom, there is no income to afford the inefficient FAI. Pure cyclical thinking in policy prescription isn't likely to get the economy out of the doldrums.

Structural reforms can revive high growth

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If China wants to revive growth, it should allow market force to function fully. Unviable businesses should shut down or be sold. China's cost structure will continue to rise due to labor and energy shortage and rising cost for environmental protection. Fragmented industrial structure is just not viable. Consolidation into the right hands could increase efficiency to offset the cost rise.

Further, China has to move up the value chain to deal with the rising costs. While China's exports are the biggest in the world, Germany and the US are not so far behind. Their labor cost is ten times China's. They are sustaining their exports by doing what China cannot. It is a big market out if China can upgrade and move into the same markets that Germany, Japan, and the US occupy now. The current industrial structure couldn't get China into the high value added market, as companies are too small and profits are too low to fund R&D. Consolidating the current fragmented industrial structure is a must if the country is to move its industrial base up the value chain.

The concentration of resources in the government sector has become a drag on the economy. This political force is the root cause for most of China's problems. The trend needs to be reversed if the economy is to move up the value chain. China should consider to decrease the government's stakes in the state-owned enterprises and to open up the industries that the SoEs now monopolize to private companies.

Demand support is worthwhile if it coincides with structural reforms. Otherwise, it would be just for propping up an inefficient and unsustainable economic structure. And, any stimulus should support consumption rather than investment to ease structural imbalance.

As I wrote in this page last time, cutting taxes is the best way to support demand. Monetary stimulus or increasing fiscal spending would only support inefficient FAI, making the situation worse down the road.

Stagnation for stability?

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The micro evidences suggest that China is trying to prop up the existing structure rather than to restructure the economy. Local governments are putting pressure on banks to support failing companies. The local government debts are likely to be rolled over too. While such actions preempt disruptive bankruptcies, businesses, banks, and local governments could all become zombies for a long time to come. Stability will be paid with stagnation.

China's attitude to the current economic challenges seems to be similar to Japan's two decades ago, emphasizing stability above all else. Japan essentially buried the consequences ot the bubble in the financial system. Businesses, banks, and local governments all became zombies. Of course, China is entering the phase at much lower per capita income. Stagflation will trap hundreds of millions of people in low income.

It is possible that China will emerge from the low growth phase on its own as businesses eventually learn to use China's labor for higher value-added activities. Import substitution and export expansion may follow, which would bring a rising tide again. But, it would be years away. Unless we see a coherent and comprehensive restructuring program soon, China may be stuck in low growth for years.

It doesn't have to be that way

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China's per capita income is only USD 5,000. The household consumption is merely one third of that due to over investment. China's living standard is still relatively low. It would be a trajedy for China to be stuck at such a low level.

Two decades ago, Japan was already enjoying per capita income similar to other developed economies'. Stagnation wasn't a bad prospect. Also, due to high cost, Japan wasn't in a position to revive high growth rate. One may argue that Japan made a rational choice to digest the consequences of the bubble over a long time.

The tradeoffs for China today are totally different from Japan's then. The country still has low cost. Through upgrading, high growth rate could be revived. The current per capita income is too low for most people.

Avoiding bankruptcies is very bad for the stock market. Failing businesses that are propped up by the banks will suppress profits for healthy companies. The banks will suffer terribly. Hence, the stock market will remain depressed due to low profitability. The government may try liquidity support for the stock market sometime this year. Its effect will be short-lived. Without a good environment for business profit, the stock market cannot perform.

As I wrote before, soft landing may not be good, hard landing may not be bad. Indeed, if China goes into a hard landing now, it will most likely push the country towards painful reforms. The economy will prosper for a long time afterwards. But, it doesn't look likely now. China's economy is slowing down in an orderly fashion, as the banks are not permitted to pull the plug on failing companies. When we celebrate the soft landing, we should remember the cost.